What is a Capped Rate?

A capped rate is a variable interest rate that can fluctuate over time, but has a cap or limit that it cannot exceed. Some examples of these financial instruments are a capped rate mortgage and a capped floating rate note. At first, capped rates seem like a win-win product because the borrower will pay the market rate if the rates fall while protecting herself by a capped interest rate if rates rise. A closer look shows that most capped rate products have a fee and a spread and over time may be less competitive than a fixed interest rate.

Traditionally, interest rates can either be fixed or variable. In the United States, these rates are usually fixed by the Federal Fund Rate. Elsewhere they may be linked to an Interbank Offered Rate such as the London Interbank Offered Rate (LIBOR) or the Tokyo Interbank Offered Rate (TIBOR). A capped rate will also be linked to a given rate, but it cannot exceed the cap; once the market rate dips below the cap, the borrower will yet again pay the market rate. This is different from financial instruments with a conversion option, which start out with a variable rate but may become permanently fixed if the option is exercised.

Here is an example of a capped-rate, 30-year mortgage held in the U.S. The interest rate varies just like an adjustable rate mortgage, but is capped at 6.75 percent. Otherwise, the borrower agrees to pay the Federal Fund Rate plus 0.5 percent. If the current adjustable rate is 5.0 percent, the borrower will pay 5.5 percent. If the adjustable rate exceeds 6.25 percent, the borrower will pay only the capped rate of 6.75 percent.

Capped rate mortgages are rare. Capped floating rate bonds are more common, as well as floored floating rate notes. They pay out interest payments that fluctuate but have a fixed maximum or minimum respectively. Capped rates are also common features of more complex derivative financial instruments.

Products that have capped rates may be very appealing to the cautious risk taker. The variable rate allows for financial opportunity if interest rates drop. The cap provides some stability and protection from volatile interest rates.

On the other hand, if rates remain constant or rise, capped rates are less of a good deal than other products. Often the security of capped rates must be bought into with hefty fees. Also, the spread or the increase from classic variable rates may add up over the years. Capped rate products may turn out to be less lucrative than traditional products.